What Is Unsecured Debt? | Personal Loans Advice
At some point in your life, you will likely need to borrow money. Perhaps you plan to take out school loans or apply for a mortgage. Whenever you borrow money, chances are good that it will be in one of two forms: secured debt or unsecured debt.
Unsecured debt is a common form of borrowing that includes traditional credit card cards, student loans medical bills. This type of borrowing is often quicker easier than applying for secured debt.
“Unsecured debt can be great in a pinch, especially when not using it will result in financial harm,” says Karen Carlson, vice president of education digital marketing at InCharge Debt Solutions, a nonprofit credit counseling organization.
But if you are not careful, unsecured debt can come with significant drawbacks. “If you are struggling to pay your bills have a high debt-to-income ratio, you should consider other options,” Carlson says.
Here is more about unsecured debt when it might be the right choice for you.
Unsecured vs. Secured Debt
The main difference between unsecured secured debt is that secured debt requires collateral: a valuable asset such as a car, home or savings account the lender can seize if the borrower defaults.
Unsecured debt is issued based on credit not backed by assets of any kind, which places the lender at greater risk of not being repaid. Lenders typically offset this risk by charging higher interest rates on unsecured debt.
Examples of unsecured debt:
Examples of secured debt:
How Lenders Evaluate Borrowers for Unsecured Debt
Your credit score is a top factor that lenders use to determine your eligibility for an unsecured loan your interest rate. Because unsecured debt poses bigger risks to lenders, borrowers usually need higher credit scores to qualify compared with secured loans. Strong credit suggests that the borrower has a history of paying back loans.
“The higher the credit score, the better the terms the lower the interest rates will be,” says Amy Maliga, financial educator at Take Charge America, a nonprofit credit counseling agency.
By contrast, people who do not have an extensive borrowing history or who have poor or no credit scores are less likely to qualify for unsecured debt. If a lender offers an unsecured loan to a borrower with a limited or troubled credit history, the loan will typically come with a low credit limit high interest rate, Maliga says.
A history of responsible financial behavior is the best way to improve your odds of approval, Carlson says.
“Pay your bills on time, don’t carry balances on your credit cards, pay down credit card balances you currently carry,” she says.
Is Unsecured or Secured Debt Better?
Which loan type is better can depend on your credit, your financial need your willingness to put assets at risk.
If you don’t have assets to provide as collateral, an unsecured loan may be your only option. But if you don’t have good credit, a secured loan could offer easier approval. Consider the distinct advantages disadvantages of unsecured secured debt to choose the right loan.
An unsecured loan may be best when:
- You have good or excellent credit.
- You don’t have or don’t want to pledge collateral.
- You don’t require a large loan amount.
A secured loan may be best when:
- You have fair or bad credit.
- You want the lowest possible interest rate.
- You need a large loan amount or long repayment term.
- You are willing to pledge an asset as collateral.
What Happens if You Fail to Pay Unsecured or Secured Debt?
Whether you stop paying an unsecured or secured debt, you will wreck your credit. But the consequences of defaulting on an unsecured loan are a bit different from a secured loan.
For both types of loans, most lenders provide a grace period before reporting late payments to the credit bureaus. You can expect late fees a drop in your credit score.
If you have an unsecured loan, your account likely will be sent to collections after a period of time. In a worst-case scenario, the lender might even sue you to try to collect the debt.
If you fail to pay a secured debt, the lender may take steps to repossess the property you pledged as collateral. The result of defaulting on a mortgage is foreclosure, which can mean losing your home.
Defaulting on a debt, regardless of type, remains on your credit report for up to seven years hurts your ability to borrow in the future.
Personal loan interest rates increased this week for the 36-month 60-month loan terms. Here are the average personal loan rates offered to well-qualified applicants with a credit score of 720 or greater, as of May 22:
- Three-year personal loan term: 19.53% (up from 19.18% a week ago).
- Five-year personal loan term: 20.37% (up from 20.07% a week ago).
Personal loan rates vary widely based on creditworthiness. Borrowers with very good or excellent credit scores will see much lower interest rates than those with fair or poor credit. Often, borrowers with bad credit will apply for a secured personal loan that uses an asset as collateral in order to achieve lower rates:
Should You Pay Off Unsecured or Secured Debt First?
Plan to make at least the minimum payment, regardless of whether a debt is secured or unsecured.
You might struggle to pay both secured unsecured debts wonder how to prioritize paying them off. If you find yourself in this position, pay off unsecured debts first, Carlson says.
“Unsecured debt is often the highest-interest debt a person faces should be prioritized to pay off first fast,” she says.
Secured debts, such as a mortgage, typically have lower interest rates, “you can make payments over a longer time horizon,” Carlson adds.
Also, unsecured debts can be easier to pay off, Maliga says, because the balances are often relatively low. “Once the unsecured debt is paid off, they can make extra payments on their secured debt to whittle down the principal balance more quickly,” she says.
But if you truly cannot pay both forms of debt, you may be better off covering your secured debt first because you have more at stake if you don’t.
“If consumers are struggling with which debts to pay, they should always pay these loans first since the collateral could be seized for nonpayment of the loan,” Maliga says.